Canada: Due diligence and unreported income penalty

In Galachiuk (2014 TCC 188), the TCC found that a taxpayer was not subject to a 20 percent penalty for repeatedly failing to report income, because he had exercised due diligence in preparing one of the returns on which he had failed to report income. The TCC found that for the CRA to impose the penalty under subsection 163(1), there must be a failure to include amounts in computing income in two different years; thus, a taxpayer can use a due diligence defence for either the first or the second failure in order to rebut the application of the penalty. In Galachiuk, the taxpayer was able to show due diligence with respect to an amount of unreported income in the 2008 taxation year. As a consequence, the court vacated the 2009 penalty for a failure to report.

Mr. G moved to Calgary in October 2008 and informed his investment broker and adviser of his change in residence. Although Mr. G also paid the post office to forward his mail (until April 30, 2009, one month after the deadline for issuing T3 slips), he did not receive one particular T3 slip. The CRA reassessed Mr. G for failing to report $683 in investment income when he filed his 2008 tax return; Mr. G did not dispute the reassessment.

In his 2009 return, Mr. G failed to report almost $437,000 in pension income for various employment benefits that he had earned. Any payments not transferred to Mr. G’s RRSP or LIRA (locked-in retirement account) on a tax-deferred basis would have been taxable to Mr. G and reported on either a T4 or a T4A slip. Mr. G received a T4A slip that recorded only 30 percent of the relevant income; the remaining 70 percent of the pension income was recorded on a second T4A slip that Mr. G claimed not to have received before he filed his 2009 tax return. Mr. G believed that only one T4A slip was issued to each employee, and he assumed that he had reported all of the relevant income.

The CRA subsequently reassessed Mr. G to include the unreported income from the second T4A slip in his 2009 income tax return; it also imposed a penalty for a repeated failure to report income under subsection 163(1) equal to 10 percent of the unreported income (not 10 percent of the related tax). Because Mr. G was an Alberta resident, a corresponding penalty applied under the Alberta Personal Income Tax Act; as a result, the combined federal-provincial penalty equalled 20 percent of the unreported income. The TCC noted the harshness of the penalty: not accounting for the tax withheld at source, the subsection 163(1) penalty exceeded 220 percent of the taxpayer’s unpaid tax. In contrast, the maximum fine for criminal tax evasion was only 200 percent of the tax evaded.

In considering whether the CRA had correctly assessed a penalty for repeated failure to report income for Mr. G’s 2009 taxation year, the TCC concluded, on the basis of jurisprudence such as Symonds (2011 TCC 274), that Mr. G could make a due diligence defence either for the first failure in 2008 or for the second failure in 2009. The issue had previously been considered only in informal procedure cases, and the outcomes in those cases were divided. The Symonds decision concluded that because the penalty was for a repeated failure, the taxpayer could avoid the penalty if he was able to show that he had exercised due diligence in either year.

The TCC found that the penalty for repeated failures to report income does not require that a taxpayer have already been reassessed for his or her first failure to report income. Thus, a taxpayer could file his or her tax return before being assessed for the previous year and therefore be unaware of a need to be cautious. The TCC believed that Finance intended that the due diligence defence should be available for either year, because the earlier year could have been assessed subsequent to the later year’s filing. The notion that the due diligence defence is related only to the second failure to report was based on an assumption that the assessment of the first failure acted as a warning. That assumption may not be true on the facts, and thus any limitation on the due diligence defence should be clearly stated. The TCC found that the penalty was harsh and potentially disproportionate to the gravity of the wrong committed, and it therefore chose an interpretation that was more favourable to the taxpayer.

The TCC was satisfied that Mr. G’s failure to report income in 2008 was inadvertent because he had taken adequate steps to ensure that he would receive his T-slips after moving. The post office forwarded other slips that were addressed to his prior residence (they were incorrectly addressed, because Mr. G had informed the senders of his change of address) and therefore it was reasonable for him to rely on the mailing system and not to make further inquiries about the missing slip. The TCC found that Mr. G’s tax return process for 2008 was adequate and thorough, and it said that a more extensive review would not necessarily have uncovered the missing slip. The TCC also noted that the unreported income was insignificant (less than 0.1 percent of Mr. G’s 2008 taxable income) and related to only one missing information slip. However, the TCC said that if the unreported amount had been a more significant percentage of his income, Mr. G would have been expected to notice its absence and take further steps.

Although the TCC concluded that Mr. G successfully established a due diligence defence for the 2008 taxation year, and therefore was not liable for a penalty for repeated failures to report income, the TCC also concluded—for the sake of completeness and in contemplation of an appeal—that Mr. G was not duly diligent with respect to 2009. Specifically, the TCC found that although it may have been reasonable for a person to believe that his former employer would issue only one T4A slip for all amounts paid to him during the year, on the facts Mr. G’s belief was unreasonable because there was a significant difference between the amount of pension income that Mr. G’s employer paid to him in 2009 and the amount reported on the T4A slip that he received prior to filing his 2009 return. Detailed documents from the employer listed the approximate amount of the receipts and their associated tax treatment. Mr. G did not review those documents to verify his reported income. The test was subjective and objective, and Mr. G failed the test of reasonableness.

Mr. G also failed to report foreign non-business income in his 2007 return, although the CRA did not rely on that failure for the imposition of the penalty. The amount of the unreported income was less than 0.02 percent of his income in 2007, and the TCC did not draw any inference from that omission. However, the 2007 notice of assessment referred to the omission and an adjustment for its inclusion. The Crown said that the adjustment should have put Mr. G on notice, but it was not clear that he had received the notice of assessment for 2007 when he filed his 2008 return. Mr. G had thus produced prima facie evidence that he was duly diligent. In obiter, the TCC said that if the Crown had proved that Mr. G had received his 2007 notice of assessment before he filed his 2008 return, the court would have concluded that he was not diligent in filing his 2008 return.

In the result, the TCC allowed Mr. G’s appeal and ordered the CRA to reassess the taxpayer to delete the penalty imposed in 2009 for repeated failures to report income.

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